Editor's note: Jimmy Zhu is chief strategist at Fullerton Markets. The article reflects the author's opinion, and not necessarily the views of CGTN.

Shanghai stocks are 21 percent cheaper today than at the end of last year, with trade tensions pervasive throughout most of 2018. For some value investors, this is a good time to start gauging buying opportunities. Analysis shows a truce may not be enough for a safe-entry into the market, but a permanent declaration on “sheathing the sword” is much needed.

Which indicator best shows the outlook on U.S.-China trade tensions?

Global investors have been trying hard to define it. Unfortunately, there hasn't been a perfect indicator. Among all the major asset classes, the U.S. dollar/Chinese yuan exchange rate could still be the most relevant one.

The U.S.-China trade tensions kicked off in early March, but most global assets remained fairly calm in the second quarter.

The reason behind that smoothness was markets underestimated the length and intensity of this trade war.

At the beginning of the conflict, many analysts merely focused on the trade war's direct impact on the two economies, but overlooked the impact on deteriorating confidence. 

The U.S. announced tariffs on Chinese imports worth 50 billion U.S. dollars in June, and China retaliated immediately.

A few days later, Trump said he was looking to put tariffs on another 200 billion U.S. dollars of Chinese exports.

The dispute quickly escalated and the yuan tumbled around seven percent versus the dollar in the next two months. When the U.S. said it would postpone an increase in tariffs on 200 billion U.S. dollars of imports on December 1, the Chinese yuan recorded its biggest gain against the dollar in over a decade in the next two trading days.

From an economic point of view, it sounds inconceivable that headline news charted the moves in the yuan, as China has a large account surplus and its exports only account for 10.8 percent of its entire GDP.

However, “herd behavior,” one of the unique characters in the China FX market, is the main cause behind the yuan's wild moves. It is much easier for a sentimental market to price in those fears and greed. 

How much impact did the Chinese yuan have on domestic stocks?   

Data shows that the Shanghai Composite Index is more sensitive to the trade war's outlook than the country's domestic policies.

A correlation between the Shanghai stocks and the yuan exchange rate reached 0.953 since the beginning of March when trade tensions started escalating, versus 0.788 in the whole of 2017.

Such a relationship explains how the trade war has had a significant impact on Chinese stocks as well. If such correlation continues, an appreciation in the yuan is much needed for stocks to recover.

On the other hand, Chinese policymakers have accelerated the pace of introducing pro-growth measures.

The People's Bank of China (PBOC) announced it would reduce reserve requirement ratios (RRRs) for major banks in June and October, on both occasions right after the U.S. imposed new tariffs on Chinese imports.

Apart from monetary measures, Chinese authorities also looked to provide more funding for private enterprises, and allowed the private sector to access more investment projects.

Still, Shanghai stocks have fallen around 8.7 percent since the end of the first half of 2018, versus a 7.1 percent drop in the MSCI EM ex-China index over the same period.

Besides slowing economic activity weighing on the Chinese stocks' outlook, existing policy aids may not be enough to offset the negative impact of the trade war.

Historically, the Chinese currency and its stock market has had little correlation. However, when the yuan is near 7.0 to the dollar, the currency is in part a restraint for further policy easing.  

Seven yuan to the dollar is "an important psychological level," according to PBOC adviser Sheng Songcheng, and China's economy will pay a high price if the currency weakens below that.

From this perspective, the U.S. Fed may indirectly mitigate the negative impact from the trade war on Chinese stocks, if it follows expectations and slows the pace of its rate hikes.

Bloomberg data shows the dollar index will drop each quarter next year to 91.2 at the end of 2019 from its current 97.5 level, according to a median forecast from a survey as of December 16. 

When the dollar index level was last at 91.2 on April 23, the U.S. dollar/Chinese yuan rate was around 6.33.

If the result of this survey materializes, greater liquidity may be allocated into the Chinese stock market as policy easing faces less barriers.